An interesting advance tax ruling was released by the South African Revenue Service (SARS) on 12 March 2014. Binding Private Ruling 164 (Ruling) deals with the buy-back of ordinary shares by a company at an amount in excess of the market value of the shares.
The facts of the proposed transaction are relatively simple. As part of a Broad-Based Black Economic Empowerment (B-BBEE) transaction, a company (BEECo) acquired 40% of the ordinary shares (shares) in a South African incorporated and resident company (applicant). The acquisition of the shares was financed by the BEECo through the issue of cumulative redeemable preference shares to various investors, the majority of which were financial institutions. As is typical in these transactions, the shares were used as security for the issue of the preference shares. If the BEECo failed to redeem the preference shares when due, the preference shareholders could take cession of the shares in satisfaction of the redemption obligations.
To ensure that the BEECo would not default on its preference share obligations, triggering the security arrangement mentioned above and compromising the applicant’s B-BBEE status, it was proposed that approximately 20% of the entire issued share capital of the applicant would be bought back by the applicant. However, the buy-back of the shares would be for an amount in excess of their market value. The BEECo would use the proceeds from the
buy-back of the shares to redeem all of the preference shares. The BEECo would then hold more than 25% of the applicant’s ordinary shares and still satisfy the B-BBEE requirements.
Where a transaction is entered into at less than or more than market value, one of the immediate concerns is whether there is a donation, as defined in
section 55(1) of the Income Tax Act No. 58 of 1962 (the Act), or a deemed donation, as contemplated in section 58 of the Act, triggering the attendant donations tax implications.
In addition, and particularly where an asset is disposed of at less than market value, there may be a concern that the disposal triggers the deeming provisions contained in paragraph 38 of the Eighth Schedule to the Act. Paragraph 38 provides that a disposal of an asset must be treated as having been disposed of at market value in, amongst others, the following instances:
- The disposal of an asset by means of a donation.
- The disposal of an asset to a connected person (as defined) for a consideration which does not reflect an arm’s length price.
Interestingly, and in line with a number of other advance tax rulings involving black economic empowerment transactions, SARS ruled that:
- The proposed buy-back of the shares by the applicant at an amount in excess of the market value thereof will not constitute a donation as defined in section 55(1), nor a deemed donation as contemplated in section 58.
- The deemed disposal at market value provisions contained in paragraph 38 would not be applicable to the proposed buy-back of the shares.
Importantly, SARS appears to accept in the Ruling that there are commercial objectives to the buy-back of the shares at a price in excess of their market value, namely to maintain the applicant’s B-BBEE status. This commercial objective appears to have satisfied SARS that:
- the excessive purchase price for shares would not be paid with a gratuitous intention (or out of disinterested benevolence);
- the consideration in these particular circumstances would be adequate; and
- the consideration reflects an arm’s length price (as contemplated in paragraph 38).
The Ruling does not provide all of the details of the proposed transaction. However, it is worth noting that if the buy-back of the shares by the applicant constituted a ‘dividend’ (as defined in the Act), for capital gains tax purposes, the proceeds from the disposal of the shares would be reduced by the amount of dividends, potentially eliminating the capital gains tax consequences for BEECo (see paragraph 35(3)(a) of the Eighth Schedule to the Act).(Editorial Comment: It is important to note that issues of dividends tax are not dealt with in the binding private ruling) However, it is anticipated that a portion of the buy-back (i.e. at least the subscription price for the shares) would amount to a reduction in contributed tax capital and thus not constitute a dividend.
It is also interesting to note that, if paragraph 38 were to apply, it would have the anomalous result that the BEECo would be deemed to have disposed of the shares at market value, which would be less than the proceeds received from the buy-back of the shares.
Taxpayers must be mindful of the potential adverse tax consequences that may be triggered whenever a transaction is not implemented at market value. It is often recommended that taxpayers approach SARS for an advance tax ruling in such instances. However, it should be appreciated that SARS has the discretion
whether or not to accept a request for an advance tax ruling on whether the amount paid for an asset constitutes a donation under section 55(1) or a deemed donation under section 58(1) (see section 80(2) of the Tax Administration Act No 28. of 2011).
Cliffe Dekker Hofmeyr
ITA: Sections 35(3)(a), 55(1), 58 and paragraphs and 38 of the Eighth Schedule
TAA: Section 80
BPR No. 164